Text 4.Customs Unions and Foreign Investment

Academic debate over the effects of the proliferation of regional trade agreements ( RTAs) has mostly focused on the trade diversion vs. trade creation question. However, a close inspection of the actual formation process of various RTAs reveals that member countries are equally concerned about the impact on the investment flows. There is widespread evidence that smaller and poorer countries (such as Eastern European or Latin American countries) want to join wealthier groups (such as the EU or the NAFTA) or form regional unions (such as Mercosur) in order to attract more foreign direct investment. The main reason is that foreign firms are more likely to invest in a country that is a member of a RTA since they can serve a larger market from a single facility and save on the fixed costs of operating a plant. The investment expansion effect improves the welfare of the member countries as a whole and creates a significant motive to form RTAs. This is indeed among the main features of what Wilfred Ethier identifies as “New Regionalism” and “Deep Integration” paradigms.

Formation or enlargement of RTAs, at the same time, can divert part of the initial foreign investment from some member countries to others. Foreign firms can relocate their regional production away from countries with high production costs and serve the integrated market from their plants in the low-cost countries. This investment relocation effect can be quite significant for cost countries and leave them worse off under the RTA compared to a unilateral trade policy. Therefore cost asymmetries among member countries leave RTAs vulnerable to defection by high-cost countries and may cause their failure even when the net gain for the region is positive.

The auto industry in Mercosur is a great example to study the phenomena mentioned above. During Mercosur negotiations, Argentina was quite concerned that low-cost Brazil would attract all of the current auto producers as well as new entrants who would find it profitable to invest in the region. The sectoral negotiations in automobiles involved numerous impasses over the years and had to be salvaged by the presidents of Argentina and Brazil on several occasions. The two governments resolved the investment relocation problem through an ingenious mechanism called “Compensated Trade Clause” (CTC) and signed the final sectoral agreement called “Politica Automotrizdel Mercosur” (Automotive Policy of Mercosur - PAM) on March 24, 2000. The CTC requires that each auto company should balance its bilateral auto trade between Argentina and Brazil. If a firm fails to do so, its exports are subject to the regular tariff rates. A balanced trade requirement forces firms to invest and produce in both countries and prevents Brazil from dominating both market sat the expense of Argentina. In other words, it mitigates the relocation problem while maintaining the benefits from investment expansion. Without the CTC, Argentina would never have agreed to free trade in automobiles and probably would have abandoned Mercosur.

More interestingly, it was the auto companies who suggested and lobbied extensively for this restrictive rule. They would have naturally preferred to locate the production of all models and varieties in Brazil but they were still able to take advantage of economies of scale by concentrating all production of a model in one plant. Firms did exactly so by producing their luxury models in Argentina and basic models in Brazil. In short, firms were aware that Mercosur with the CTC was a better option than no Mercosur at all. It is also interesting to note that the CTC is enforced at the firm level. This prevents the free-rider problem that arises when each firm desires its competitors to invest in Argentina to save Mercosur for everyone’s benefit. Thus the CTC not only helps the governments to agree to regional free trade in automobiles but also increases the firms’ profitability.

There are of course more efficient mechanisms, such as direct transfers, that would convince Argentina to sign the Mercosur. However these are politically difficult to negotiate and implement since they would require transfers between the auto firms, Brazil and Argentina. The compensated trade clause is attractive in terms of domestic politics since it is based on “fair trade”, as the trade ministers of both countries remarked many times. Therefore, although it is economically inefficient, the compensated trade clause is strategically necessary for the establishment of free trade in automobiles and realization of the benefits from it for all parties.

Source: Ozden, C. Customs unions and foreign investment: theory and evidence from MERCOSUR's auto industry / C. Ozden, F.J. Parodi. – Santiago, 2004. – 31, [5] p.

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